Could we really see the end of the tax-free lump sum? How George Osborne's tax raid could eat a prized part of your pension

George Osborne is rumoured to be planning a raid on the tax-free lump sum perk enjoyed by pensioners.

Savers already facing up to the prospect of the principle of tax-free pension saving being hacked back by the removal of full higher rate tax relief have been warned that the much prized tax-free lump sum is also be under threat, if a full on revamp to an Isa system arrives.

This would hit a chunk of pension saving that is taxed neither on the way in, or way out.

We take a look at how likely this is to arrive in March's Budget and what these changes could mean for your pension.

The end of the tax-free lump sum: Osborne could replace the lump sum with a pension Isa

What is the tax-free lump sum?

Currently, whenever someone comes to retire and takes their pension they can withdraw 25 per cent of their pot tax-free.

For those with defined contribution pensions the system is simple. If you had £100,000 of retirement savings, you could take £25,000 out tax-free before deciding what to do with the rest.

The remaining £75,000 could be used to buy an annuity, go into drawdown or cash out. All withdrawals thereafter will have an income tax at your own personal rate.

If you choose not to take a tax-free lump sum and instead remain invested and draw out smaller lump sums, the first 25 per cent of each is tax-free and the rest taxed.

For those with defined benefit pots - typically referred to as final salary or career average schemes - a 25 per cent tax-free lump sum is still available. The value of your pension pot is calculated based on what your promised retirement income is, you can then take 25 per cent of that whole pot value as a lump sum tax-free. Your remaining pot then pays a reduced income.

If your retirement income is too low to qualify for income tax at all, or you were a higher rate taxpayer while working but moved onto the basic rate in retirement, that also effectively gives you a tax advantage.

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HOW THIS IS MONEY CAN HELP

George Osborne is under pressure to cut the deficit (thanks largely to his own promise to balance the books) and the pension tax relief bill is a big one.

He has given savers and pensioners flexibility in recent years under pension freedom rules - effectively giving savers over 55 unfettered access to their retirement pots.

But now those yet to retire could be in the firing line for a tax raid.

Anyone saving into a pension benefits from tax relief on the way in as well as the 25 per cent tax-free at retirement. This principle of tax-free pension saving dates all the way back to the Finance Act of 1921.

But this is judged to be expensive, especially the chunk going to higher rate taxpayers (who get more of it, as they pay more tax).

'Pensions-Isa': Former pensions minister Steve Webb predicts a pensions Isa could spell the end for the 25 per cent tax-free lump sum

Tax relief costs the Treasury £34billion a year, and the 25 per cent lump sum alone is believed to cost £4billion.

Instead, the Treasury has been consulting on ways to reform pensions tax relief which could see it scaled back, or replaced with an Isa-like system.

Much of the focus has been on the prospect of cutting tax relief to a flat rate, of potentially 20, 25 or 30 per cent.

But former pensions minister Steve Webb, who now works as an adviser for Royal London and has started writing regular pension expert columns for This is Money, has warned that he beliefs the Chancellor's favoured option has long been an Isa-style scheme - and a knock-on effect of that would be to remove a chunk of money that is tax-free on the way in and tax-free on the way out.

A ‘pension Isa’ would effectively mean your contributions are taxed on the way in, but not taxed when you take them out.

But this also means the tax-free lump sum would ultimately be extinct as a result.

That's because all the money taken out would be tax-free.

However, this would kill off the element where a chunk of money gets complete tax-free status when saved and drawn.

This chunk is tax-free when saved - due to tax relief on pension saving - and free of tax on the way out thanks to the 25 per cent lump sum rule.

He said: ‘If the Chancellor decides to go for the ‘pensions Isa’ then the idea of a tax-free lump sum would completely disappear for all new savings.

‘The reason for this is under the Isa approach your income is taxed in full when you earn it, and you then pay no further tax (always assuming you can trust future governments not to change their mind).

'Under this approach, all withdrawals in retirement are tax-free, whether taken as a pension, a lump sum or a mix of the two. But, of course, that is only because you’ve already paid all the tax upfront. So this would be much less generous than the current system.

‘One of the attractions to the Chancellor of going down this route is that he would never have to stand up in Parliament and say he was "abolishing" the tax-free lump sum – it would simply disappear for new pension savings when the Isa-style pensions came in.’

The Chancellor will announce the outcome of the consultation and any changes to tax relief during his Budget on 16 March.

What difference could it make?

Scrapping the tax-free lump sum is not actually a new idea.

In 2014, Michael Johnson, a research fellow at think tank the Centre for Policy Studies, suggested the ‘regressive' 25 per cent tax-free lump sum should be scrapped.

He said the prospect of a tax-free lump sum, which costs the Government £4billion a year, does not incentivise young people to save and only helps the wealthy. He does, however, argue that any tax-free lump sum rights already accrued should be honoured.

Even before that, this idea was also considered by another Conservative chancellor, Nigel Lawson, in 1985, but subsequently dropped.

In his 1985 Budget, Lawson described the tax-free lump sum as 'anomalous but much loved'.

What is the Chancellor likely to do to pensions?

The tax-free lump sum is just one relief that could be a target in the Budget.

As mentioned above, there is also a serious prospect that the tax relief on contributions will be scaled back, and the ever present threat that the annual and lifetime allowances being reduced further.

The Government presently rebates all the tax on people's pension contributions, up to certain levels, whether you pay income tax at the 20 per cent, 40 per cent or 45 per cent rate. Your pension is only taxed when you start making withdrawals in old age.

Pension experts predict a new system of flat rate tax relief for all earners of anything between 25 per cent and 33 per cent at the more generous end. This would mean that regardless of the rate of income tax you pay, you would receive tax relief at one rate.

The 33 per cent rate was actually floated by Mr Webb, when he was part of the Coalition Government.

At this level, everyone would get a 50p tax rebate for every £1 they saved towards old age - dropping £1.50 in total into their pension pot.

Most pension savers can currently put up to £40,000 into a pension each year.

He said in return for this, savers should see the lifetime allowance scrapped.

There are already plans to hack away at tax relief for the highest earners, many of whom have been hit by the falling lifetime allowance, which is based on the entire value of a pension pot including investment gains.

The size of the annual allowance will be reduced on a sliding scale from £40,000 to £10,000 for those making between £150,000 and £210,000 a year.

Aside from the tax relief element, Osborne might do some further tinkering with everyone else's £40,000 annual allowance, or how much unused allowance people are able to carry forward from previous years.

Savers are currently allowed to roll over unused annual allowances up to a maximum of £120,000, on top of their annual allowance in the current year.

Meanwhile, the lifetime allowance, the total amount people can put in their pension pot during their lives and qualify for tax relief, is being cut from from £1.25million to £1million from the 2016-17 tax year, and index-linked to inflation from 2018-19. But there is nothing to stop there being even further reductions.

How quickly could it happen?

The Chancellor has a nasty habit of bringing in big tax changes quickly to avoid anyone finding loopholes. For example when he changed the stamp duty thresholds from a slab to a progressive system in his 2014 Budget, the changes came in at midnight.

He could bring in any changes to pension tax relief straight away to stop people piling money into their pensions ahead of the changes.

However, it is thought that any changes would only apply to new pensions rather than those who have already built up savings.

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